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May 22, 2013

Bernanke Talks and 10-Year Treasury Yield Zooms Past 2%

A premature tightening could lead to a short-term hike in interest rates but would also risk ending the recovery, the Fed chairman warns

Federal Reserve Chairman Ben Bernanke said Wednesday that the Fed was in no rush to end its easy-money quantitative easing program because the U.S. jobs picture remained weak overall while inflation was low. The Treasury bond market responded with a drop in prices and a rise above 2% in the 10-year note yield.

But even as low interest rates have helped create jobs and support home prices, savers who rely on interest income from savings accounts or government bonds are receiving very low returns, Bernanke acknowledged in prepared remarks before testifying before Congress’ Joint Economic Committee.

“Another cost, one that we take very seriously, is the possibility that very low interest rates, if maintained too long, could undermine financial stability,” Bernanke said in his remarks. “For example, investors or portfolio managers dissatisfied with low returns may ‘reach for yield’ by taking on more credit risk, duration risk or leverage.”

But ending QE can’t guarantee that outcome, he said: “Unfortunately, withdrawing policy accommodation at this juncture would be highly unlikely to produce such conditions. A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

In early afternoon trading, the 10-year Treasury note was trading up 4.78%, 0.09 points higher, to yield 2.04% versus the day’s open of 1.93%.

Anthony Valeri, fixed-income market strategist for LPL Financial, said the bond market’s response reflected uncertainty about where the Fed is ultimately headed.

“Unfortunately, I don’t think Bernanke clarified anything today,” Valeri said in a phone interview about an hour into Bernanke’s congressional testimony. “The market knew that tapering QE was going to happen sometime this year. But as for Bernanke’s comments about doing it over the next few meetings depending on the economic data—we already knew that. That creates nervousness in the bond market because we don’t have clarity.”

The 10-year rallied right after the release of Bernanke’s prepared comments, “which were quite dovish,” Valeri said. A strong equity market reaction then led to the Treasury selloff, he said, noting that the Japanese yen also weakened substantially as money left that safe-haven currency.

In an analyst note, Jim O’Sullivan, chief U.S. economist at High Frequency Economics, agreed that Bernanke’s testimony was “fairly dovish,” with no mention of tapering. O’Sullivan then mentioned a Tuesday morning interview with New York Fed President William Dudley on Bloomberg TV, where Dudley suggested that officials could potentially start tapering in “three to four months,” but for now there is too much uncertainty.

“The words appear consistent with our expectation that tapering could start by the September FOMC meeting,” O’Sullivan wrote.

Bernanke in his remarks also pointed to favorable factors in the economy, including real GDP’s estimated rise at an annual rate of 2.5% in the first quarter and an unemployment rate at 7.5%, down half a percentage point since last summer. In all, he said, payroll employment has risen by about 6 million jobs since its low point, and consumer price inflation has been low, with personal consumption up only 1% over the 12 months ending in March.

Congress came in for criticism from Bernanke. He said that fiscal policy at the federal level has become significantly more restrictive, to the point of harming the U.S. economy. Throughout his congressional testimony, he kept sounding the warning that although near-term fiscal restraint has increased, much less has been done to address the government's longer-term fiscal imbalances.

“The expiration of the payroll tax cut, the enactment of tax increases, the effects of the budget caps on discretionary spending, the onset of the sequestration, and the declines in defense spending for overseas military operations are expected, collectively, to exert a substantial drag on the economy this year,” Bernanke said. “The Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about one and a half percentage points during 2013.”